Vacancy and Credit Loss – How It Impacts a Real Estate Analysis!

The reality of owning rental property is that you will rarely encounter a situation where the property is occupied all of the time or where tenants can always be counted upon to pay their rent.

In truth, the reality about investment property is that real estate investors will suffer potential rental income loss due to both vacancies and nonpayment of rent by tenants in what is formally known as Vacancy and Credit Loss.

In any real estate analysis this is factored in as a deduction from gross scheduled income (i.e., the property’s potential rental income at total occupancy) and results in the gross operating income (i.e., the amount of actual revenue expected to be collected).

Gross Scheduled Income
less Vacancy and Credit Loss
= Gross Operating Income

This is true for income properties consisting of one unit or a multitude of units; whether the property is residential (i.e., occupied by tenants as a residence such as a single-family home or apartment building) or non-residential (i.e., occupied as a place of business such as an office building or strip center).

Real estate investors always account for an estimate of future losses resulting from turnover and noncollectable rent and factor it in to their real estate analysis as vacancy and credit loss.

There is, of course, no one rate for vacancy that correctly applies to all income properties because it is market-driven. That is, in one location where the supply for residential or commercial property is limited, demand will tend to be high and the vacancy rates low accordingly; whereas in locations where developers exceed demand with an over supply, the opposite is true.

Economic times also play a part. In times like ours, for instance, where house foreclosures have run rampant over the past several years, the demand for residential rental space has increased; all the while because jobs have been lost, businesses have closed or are reluctant to expand, thus reducing the absorption of commercial space or in many cases caused tenants to default on their payments to their landlords.

How to Calculate

Vacancy and credit loss is generally estimated as a percentage of gross scheduled income. For example, if we assume that your property would generate $50,000 a year fully occupied (i.e., the gross scheduled income) and want to allow for a 5% vacancy and credit loss, we would estimate your loss of revenue to be $2,500 revenue for that year.

Suggestion

Always plug in a rate for vacancy and credit loss whenever you are doing a real estate analysis regardless what you may think or what the current owner is projecting for the property. Even when the owner can prove that he or she has experienced zero (or very low) vacancy as the landlord, bear in mind that every property experiences vacancy from time to time for any number or reasons. So be sure to include some vacancy rate. Your local market will dictate what’s reasonable.